I will be sharing my opinions, and those of some others I respect, on how the investment business works, or fails to work, for the portfolio owner. My focus will be on portfolio construction or destruction depending on the topic of the day! Hopefully we can find a way to laugh at it all!

Sunday, April 22, 2012

Investor Traps: Covered Call ETFs

One significant challenge for investors is to ignore
information that they discover while researching investment options. A classic
example of this is information which seems straight forward but may not be
suitable for the portfolio strategy an investor is trying to implement. Part of
the challenge is that the marketing arm of the product manufacturers (mutual
fund or EFT companies specifically) do a great job of hyping the benefits and
an even greater job of downplaying or ignoring the risks of the product. Often
new investment products are created for a specific requirement, such as
enhancing income or hedging a long position and then they become popular as the
“new hot product”!

Let’s look at the example of Jane Smith, an investor in her
60’s approaching retirement shortly and managing her portfolio with a
conventional diversified ETF portfolio. Her holdings include ETF’s tracking the
TSX60, the S&P 500, EAFE Index (Europe, Australia & Far East) and the
Dex Bond Universe. Jane has a strategic asset allocation that is 75% fixed
income and 25% equity exposure. This strategy is designed to protect her
substantial RRSP holdings from market volatility while holding sufficient
equity exposure to protect against any uptick in inflation through equity growth.
Jane is looking for returns of inflation plus 2%.

In researching her investment options Jane comes across a
new ETF that has been gaining in popularity; a fund that writes covered calls
on bank shares. In checking out the ETF Jane sees that the current yield is
over 6% at a time when her fixed income portfolio is yielding 3.68% in
comparison. Given her concerns about the low interest rates on her large fixed
income portfolio Jane contemplates reducing her fixed income ETF holdings by 10%
of the portfolio and adding 10% to a “covered call elf” holding.

What Could Go Wrong?

In further reviewing the covered call strategy Jane starts
to feel a little less excited about her new strategy. While current yield is
great, Jane begins to understand that the greater yield comes with certain
risks that are not always readily apparent. That prompts Jane to run through a
few scenarios to see how her “new” strategy would react to certain market
changes that might occur.

1-What if interest rates remain low or even
go lower? The covered call strategy is based upon implied volatility in
stock prices so it does not directly react to interest rate changes. As such it
does not directly assist the portfolio to have low interest rates; however if
the ETF continues to provide a 6% yield it should have a positive impact on
Jane’s portfolio.....right? In fact, since current yield is defined as recent
period income divided by portfolio value, a $6 income on a $100 portfolio
provides a 6% current yield. If the portfolio drops in value to $75, the
current yield becomes 8%. In looking at the 1 year performance of the new fund
(just over 1 year old now) Jane discovers the rate of return has been -1.5%
from March 2011 to March 2012. That seems perplexing given the fund is yielding
such a high amount? Maybe current yield is not the best way to look at this ETF!

2-What if rates rise sharply? If rates
rise the value of Jane’s existing fixed income will likely drop. Fixed income
values generally move opposite of interest rates. Obviously the higher rate
scenario favours holding covered calls versus fixed income..... right. Well,
maybe! If rates rise what will the bank stocks held by the ETF do? Will
investors sell stock and buy fixed income when rates rise? If so what will
happen to the value of the underlying bank stock? In fact, banks tend to
benefit from higher interest rates (think of interest rate spreads as banks
raise mortgage rates and credit card rates). While no outcome is guaranteed,
Jane is comfortable that if rates rise this strategy should be either slightly
positive or neutral in her portfolio.

3-What if stocks go on a big bull run? If
bank stocks benefit from positive stock markets there could well be a doubling
or tripling of some bank stocks. After all, TD Bank common stock went from the
high $20’s to the low $70’s after the 2008 crash ended! Holding the long
positions on bank stock in the ETF might bring a real growth spurt to the
portfolio. Right? Well, actually no. While the ETF holds a lot of bank stock,
the gain from an increase in the underlying stock values would benefit the
investors that bought the covered call options. If a stock was valued at $60
and a covered call was sold at $62.00, the ETF would make a profit of $2.00
plus the option premium of perhaps $1.00. If the bank stock went to $80/share
the ETF would still only see a maximum of $3.00 from the $20.00 increase!
Suddenly giving up a $20/share gain for $3 does not seem as positive.

4-What if the stock market plunges downward?The covered call strategy is a “defensive
strategy” (according to the marketing material anyway) so it must protect my
portfolio from large losses.....right? It would seem to make sense that the
offset to sacrificing large gains when markets rise (scenario 3 above) would be
that my portfolio would be sheltered from large losses in return..... right? Well, actually, no! That is not the case with
covered calls. If the bank stocks dropped from $60/share to $40/share the fund
would need to hold the shares for the length of time that the call option
remains in place to insure the option remains a “covered call” and not a “naked
call”. The fund holds the stock regardless of the market performance and the
only income to offset the loss is the small call premium (our $1 theoretical
premium as above). The net result is that the fund looses $19/share instead of
the $20/share the market drop infers.

Given
the above analysis, Jane pulls out her original Investment Policy Statement and
reviews her strategy. The equity holdings are designed to provide growth which
protects the portfolio from being eroded by inflation. That is accomplished by
using gains from a rising stock market to cushion any losses in fixed income
values caused by inflation. Since the covered call strategy limits market gains
the covered call strategy works against Jane’s overall strategy.

Jane's original strategy called for limited equity exposure to ensure stock market
losses do not diminish Jane’s nest egg. The covered call strategy leaves the
portfolio exposed to any significant market drops so that also works against
Jane’s original strategy.

Decision:
In looking at all options Jane realizes that the covered call option is a
higher risk strategy than holding fixed income and it has the potential to 1)
dampen equity growth, 2) expose the portfolio to large equity losses, and 3) in
a low volatility stock market with concurrent low interest rates, it could
increase current yield slightly. In short the covered call strategy can help a
little or hurt a lot, but it cannot significantly improve her portfolio. Jane
reviews her portfolio performance against her goal of making returns of
“inflation plus 2%” and finds she is currently still meeting her target rate of
return. As such she decides not to utilize the covered call ETF that all her
friends are excited about. What she will do is file away the information. Every
product serves a purpose but not every purpose serves a portfolio strategy. In
this case doing what is popular with investors today and what appears to offer
some immediate benefit, would actually weaken the investment strategy and change the
risk profile on Jane's portfolio. Sacrificing equity gains while taking full
equity market risk is a poor trade off. As well, not making the addition to the
portfolio keeps the MER lower, reduces trading costs to rebalance the
portfolio, and makes the portfolio simpler to monitor. Jane knows that an
investment portfolio is like a bar of soap....the more you handle it the
smaller it tends to get!

Note:
Covered calls on bank equities were the most popular strategic ETFs in the
first quarter of 2012. The largest volume growth was a bank shares focused
covered call ETF that provided returns of just over 7%. Holding direct common
shares in TD bank provided over 10% capital gains as well as additional dividend
income. The covered call strategy provided an enhancement in returns versus
fixed income however it provides the risk profile of equity. When properly
compared to narrow focused bank equity returns the results were less than
stellar. The message is not that covered calls are a bad strategy for
everybody. The important message is that any security you purchase needs to
support your overall investment strategy, your portfolio risk profile, and your
investment return requirement. Covered call strategies are marketed as a lower
risk strategy and generally compared to fixed income investments. In fact they
are equity and should be considered a higher risk strategy with a potential
downside far greater than any typical fixed income strategy. Risking a 20% or 30%
downside or missing a 20% or 30% gain are high prices to pay for the extra
yield you may see in the short term.